“The significant problems we face cannot be solved at the same level of thinking we were at when we created them.” Albert Einstein (1879-1955)

Monthly Archives: March 2015

We frequently receive updates in our email in-boxes about various pension funds and their returns in 2014, and not surprisingly the numbers vary quite a bit. According to Wilshire’s TUCS comparisons, the average public pension plan was up 6.76% in 2014. However, we’ve seen some funds reporting returns closer to 10%. It seems to us that a plan did better the more traditional the plan’s asset allocation, meaning more equities and fixed income, and less in alternatives, particularly hedge funds.

In most cases the announcement of a total return was hailed as good or bad depending on how it did relative to the plan’s return on asset assumption (ROA). However, is that really the true objective? If a plan generated a 10% return and its ROA was 8% (49% of public plans have 8% as their ROA) it was reported as a great year. However, what did the plan’s liabilities do in 2014? Since most sponsors and consultants assume that liabilities grow at the ROA, they would likely assess that 2014 was good on both the return and liability front. Unfortunately, they would be wrong.

With the precipitous decline in US interest rates continuing through much of 2014, the average defined benefit plan had its liabilities grow more than 15% in 2014. Given this fact, I’d say that any return that didn’t exceed liability growth was a poor year, with the average public pension (6.8%) doing quite poorly versus liability growth.

Can you imagine if you were playing a football game without a scoreboard? Let’s assume you are in the fourth quarter and you’ve scored 27 points. How do you play your offense or defense? Do you get more conservative or aggressive? You don’t know, do you? Exactly! Well, this is how Pension America is playing the game.

A significant majority of DB plans only get a look at their liabilities every 1-2 years, and the results are usually presented with a 3-6 month lag. It is quite difficult to have a responsive asset allocation when you don’t know whether or not you are winning the pension game versus your liabilities, just as it is impossible to play football if you don’t know how your opponent is performing.

At KCS we place liabilities and the management of plan assets versus those liabilities at the forefront of our approach to managing DB plans. Pension America has seen a significant demise in the use of DB plans, and we would suggest it has to do with how they’ve been managed. Focusing exclusively on the asset side of the equation with little or no regard to the plan’s liabilities has created an asset allocation that is completely mismatched versus liabilities. It is time to adopt a new approach before the remaining 23,000+ DB plans are all gone!

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I had the opportunity this past Monday to attend the Opal Financial Group’s “Investment Consultants Forum”. There were many interesting topics covered during the day, including my session on “Asset Allocation Strategies in a Volatile Market”. However, there seemed to be outsized interest in the active versus passive discussion, especially as it related to U. S. equities.

I listened intently to the discussion, as I’ve been a student of the markets, products, cycles, etc, for much of my 33 years in the business. I was disappointed by the responses that I heard, especially from one consultant who “favored” active because their firm can pick superior “alpha generating” managers on a consistent basis.

I did not hear one consultant address the real issues related to why active and passive approaches both make sense depending on the environment, and how active managers are influenced by their own portfolio construction biases.

Most active managers (there are always exceptions) have a value tilt to their stock selection criteria / factors, tend to build equal weighted portfolios, which creates a small cap bias vis a vis the large cap indices, and they maintain some residual cash, even if they aren’t making an asset allocation call. Given these portfolio construction biases, it is fairly easy to understand that active managers aren’t going to perform well in strong up markets, favoring mega cap firms, which is where we’ve been! The passive index benefits from being fully invested, and the large cap bias (market weighting) is further fueled by the momentum (non-value indicators) driving the these large cap stocks and the markets.

As you can imagine, these trends are further exacerbated by strong positive cash flows into the recently better performing segments of the market, whether that be retail or institutional money, as neither group exhibits an ability to be a Contrarian.

Given the portfolio construction biases that exist, what is likely to happen in the passive / active relationship in the next 1-2 years? We believe that it is time to reduce one’s exposure to passive strategies (not eliminate), as we see small and mid cap stocks leading the US markets in the near-term. Why? First, the strengthening US $ will negatively impact the earnings and profits of US mega cap companies that derive a meaningful percentage of their revenue from overseas activity. Second, large cap stocks (S&P 500 as proxy), fueled in part by the aggressive move into passive approaches, have beaten small cap stocks (R2000 as proxy) by 9+% in the last 12 months, and have performed in line for the last 10 years, despite small cap stocks supposedly being more risky and less liquid (where’s the compensation?).

We would suggest that you move your large cap allocation to the bottom of your target range, while increasing small to mid cap to an overweight exposure. Furthermore, if you have a target allocation for both active and passive exposures that you shift more assets into active US equity approaches at this time. After 6 years of US equity strength, large cap dominance, a strengthening $, and a slight style outperformance by growth versus value, we think that the time is right for active managers to begin to add value, while benefiting from the biases that they create in their portfolios.

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KCS was recently invited to participate in a finals presentation for a small public defined benefit plan. We were one of six consulting firms to present that evening, and fortunately, the last firm to present on what turned out to be a very late evening.

As I predicted, each of the firms that preceded us talked about how they would go about achieving the prospect’s 7.5% return on asset assumption (ROA) through “superior” asset allocation strategies and manager selection. I attempted to throw cold water on their claims by stating that hitting the ROA was basically irrelevant, especially given the poor funding status of this plan, and that the only true benchmark / objective for a plan sponsor’s DB plan should be their plan’s liabilities.

According to Trust Universe Comparison Service (TUCS), the average public pension had a 6.8% return in 2014. This result fell slightly below most public pension return objective, but it wasn’t devastating on the surface, especially if one only focused on the asset side of the pension ledger. However, and in fact, 2014 was a bad year for Pension America, as a further decline in US interest rates exacerbated liability growth by more than twice asset growth.

In attempting to differentiate ourselves from the competition we stressed the need for plan sponsors to get an update on their liabilities more often that once every year or two, delayed 6 months, until they received their actuarial reports. It is our claim that asset allocation should be driven by the plan’s liabilities, funded ratio and contribution policies, and not the assets.

As one would expect, our claims were met with skepticism, since each of the firms that went before only spoke about assets and the ROA. We were told that asset consultants focus on the asset side because they are “tangible” and liabilities are not. REALLY? What is more tangible than a promise that has been made to a plan participant? Like assets, liabilities can be priced daily. They are bond-like in nature and are impacted by changes in the interest rate environment and benefit formula adjustments. The present value of future DB plan liabilities have grown substantially during the last 15 years, as US interest rates have plummeted.

What did plan sponsors do? They exacerbated the situation by creating a huge mismatch between their plan’s assets and liabilities by reducing exposure to traditional US fixed income. Why? The yield on US bonds declined to less than the ROA, and they argued (as did their consultants) that fixed income would become a drag on the portfolio’s return. Focusing on assets, and not liabilities, has had a devastating impact on the funded status of America’s DB plans (particularly multi-employer and public pensions).

As if that wasn’t enough, yesterday I spoke at the Opal Financial Groups “Investment Consultants Forum”. Notice that it wasn’t titled the “Investment and Liability Consultant Forum”. I spoke on asset allocation strategies with two others. Neither of my fellow panelists spoke about needing to understand the objective, and they certainly didn’t address a plan’s liabilities. In fact, one gentleman from a leading asset consulting firm talked about his firm using a model portfolio. Given that every client’s liabilities are different, how can there be such a thing as a model portfolio for a DB plan? This business never ceases to amaze me!

Pension America is in crisis due to the demise in the use DB plans. It will only get worse if we continue to support the notion that only the asset side of the pension equation is relevant. We better embrace a new approach before it is too late, as the same old, same old isn’t working and it won’t start now. There is nothing more tangible than a promise made. Not having the financial resources to meet that promise would be devastating for the participant.

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We are pleased to share with you the latest edition of the KCS Fireside Chat series. The March 2015 article focuses attention on the need for plan sponsors of qualified retirement plans to restate or rewrite their plan to conform to current law. The IRS is responsible for overseeing this process. We hope that you find our partner, Dave Murray’s insights helpful. The link follows: